Sunday, December 3, 2017

BIS: Echoes of Greenspan's conundrum in bond markets

A paradox reminiscent of Alan Greenspan's "conundrum" in the 2000s is playing out these days as global financial conditions have become easier ever since the U.S. Federal Reserve began its gradual but persistent tightening of monetary policy two years ago, according to the Bank for International Settlements (BIS).

Since the Fed in December 2015 raised its federal funds rate for the first time in almost 10 years, stock markets have surged, the yield on benchmark 10-year U.S. Treasury notes has moved sideways, corporate credit spreads have narrowed, and a key indicator of the tightness of overall financial conditions index has dropped to lows not seen in the last 24 years.
"Can a tightening be considered effective if financial conditions unambiguously ease?," asks Claudio Borio, head of BIS' monetary and economic department, as the world's oldest international financial institution releases its December quarterly review.

In fact, such a paradoxical outcome in financial markets is not entirely unheard of but reminiscent of the Fed's tightening from July 2004 to July 2006 when the benchmark fed funds rate was hiked to 5.25 percent from 1.00 percent.

During the first year of that tightening cycle, stock markets rose while long-term Treasury yields and corporate spreads dropped, leading former Fed Chairman Greenspan in 2005 to describe the fall in bond yields as a conundrum.

The reaction of financial markets in the 2000s was in sharp contrast with previous cycles of monetary tightening, especially the one in 1994 when the Fed's action triggered sharply higher yields, stock market losses, wider credit spreads and massive currency depreciation in emerging markets.

One explanation behind the apparent paradox may lie in the overall economy. Market participants today are anticipating a future of even lower interest rates and possibly inflation than the Fed has communicated.

"Less appreciated perhaps, the very mix of gradualism and predictability may also have played a role, " says Borio, adding the expected pace of Fed tightening in this cycle is now expected to be the slowest on record.

Unlike 1994, when the Fed's move was steep and less thoroughly communicated to markets, central banks are now much clearer and transparent in their policy direction, with "forward guidance" and interest rate forecasts an integral part of their monetary toolbox.

"And scorched by the outside reaction in 1994 - not to mention the "taper tantrum" in 2013 - the central bank has made every effort to prepare markets and to indicate that it will continue to move slowly," said Borio in remarks accompanying BIS' latest review.

The effect of this gradualism by the Fed is comforting financial markets with the belief that tighter policy will neither derail the economy nor upset asset markets. And if there are tensions in financial markets, central banks will not remain on the sidelines.

Even the pace of the Fed's planned run-down of its holding of U.S. Treasuries - an average of $18 billion a month until the end of 2018 - is slower than the large-scale asset purchases in the wake of the Global Financial Crises, which ranged from $45 billion to $75 billion a month.

The monetary tightening has not yet really begun and vulnerabilities built up during the unusually long period of low interest rates are still there along with frothy valuations of all assets. And the longer this level of risk taking continues, the higher the exposures become.

"Short-run calm comes at the expense of possible long-run turbulence," said Borio.

Click to read the BIS December 2017 Quarterly Review.
In addition to a revamped and more timely commentary on developments in global banking and financial flows, the December review includes an analysis of credit risk transfers in which the authors document how global banks shift credit risks out of financial centers and riskier emerging market economies and into advanced economies.
The review also includes two special features that shed light on how the stock of debt affects macroeconomic developments and financial stability. This helps show how monetary policy normalization will affect economic activity.